IRA Basics: Understanding Your Retirement Account

Regardless of whether you already have an IRA or are interested and in need of getting an IRA, this blog will provide some helpful information to better understand this investment account. 

To begin, I want to break down two common misconceptions about IRAs. First, let me dispel the idea that an IRA in and of itself is the investment. It absolutely is not. It is just the vehicle that contains different types of investments such as mutual funds, index funds, stocks, bonds, and REITs. You need to understand this to better understand your own IRA and to know exactly where your money is invested. Don’t be misled into thinking an IRA is THE investment.  

The second misconception is that an investor can NOT touch his or her money until age 59 and a half. That is not exactly true. You may withdraw contributions from a Roth IRA at any time tax and penalty free. But in order to withdraw contributions penalty free, you must follow one of the two rules: 

  1. The Roth Conversion Ladder: 

A Roth IRA Conversion Ladder entails moving your money from a tax-deferred account, such as a 401k or Traditional IRA, into a Roth IRA. The benefit is that it allows you to withdraw the converted funds from your Roth IRA after only five years.

  1. The Rule 72(t): 

Rule 72(t) permits you to establish a schedule of annual or more frequent withdrawals from your retirement account called SEPPs (substantially equal periodic payments). When you withdraw money from a qualified retirement account under Rule 72(t), the funds are distributed to you as SEPPs. These regular payments are made over the course of five years OR until you turn 59½.

If you have interest in one of these two routes, I highly recommend working with a CPA to ensure accuracy and completeness (why does this remind me of Deloitte auditing assertions? haha)

Now let’s dive into some additional facts about IRAs.  

  • First, understand that you are not permitted to keep funds indefinitely in a Traditional IRA. You will need to take minimum distributions known as RMDs when you reach 70½ unless you were born after July 1, 2019. If you are born after that date, you will not have to take RMDs until you reach 72 as per the Secure Act.  
  • Another important concept about IRAs is that there are two types which often confuses people. Simplistically, the difference between the two, a Roth IRA and a Traditional IRA, is when you will pay taxes. If you want to pay the taxes initially, you would invest in a Roth IRA compared to paying taxes later which you would do with a Traditional IRA. 

So which is the best investment for you?  This is not a clear cut answer, but one that is unique to each investor as based on his or her financial situation. Let’s break this down to the basics to make some sense of what is best for you. The general rule is that if your income tax bracket is going to increase in the future, you will want to invest in a Roth IRA; you should choose a Traditional IRA if your income tax bracket will decrease in the future. So assess your personal financial situation before deciding which type of IRA is best for you. Again, that is the general rule as of today, but that is always subject to change, and it is difficult to determine a person’s income in thirty or so years. Think about when you want to pay the tax. Do you want to pay on the initial investment now, or do you want to wait and pay later on the compound growth of your investment?  

Roth IRAs also carry some income limits which investors need to understand. I think that whenever the Government attaches restrictions, you need to be alerted to the reasons why. The income limits known as MAGI for the Roth IRA in 2022 were as follows:

  • Single  – $129,000.00 which phases out at $144,000.00
  • Married Filing Joint – $204,000.00 which phases out at $214,000.00

You will need to assess your financial situation to determine what is best for you, but if your MAGI is below these limits, I would strongly consider investing in a Roth IRA. However, if you do go above these limits, you can still take advantage with a Backdoor Roth IRA. Wealthy people often utilize this investment strategy which is perfectly legal, just a bit unconventional and less well known. A Backdoor Roth IRA means you invest in a Traditional IRA and then convert that invested money into a Roth IRA. Not only is this method employed by those who are wealthy but also by those who have a Traditional 401k who want to split pretax and post-tax money.  

Since it is not a black and white, clear, and easy decision between a Traditional pre-tax or a Roth post-tax IRA, many times there needs to be a combination approach. On a personal note, this is what I do. You will need to consult with a CPA you trust and who is well-versed to help determine what is best for your financial situation.  

The good news is that you are able to recharacterize IRA contributions in order to change the initial designation. So, for example, if you made contributions in a Roth IRA and then realize you exceeded the Roth IRA income limits, you may recharacterize it to a Traditional IRA contribution. 

To determine which IRA is best for you and your retirement, you will need to calculate your GROSS annual income. It is commonly recommended to invest about 15% of your gross annual income into retirement. Good steps to follow for where to allocate your 15% are: 

  • Invest up to the limit of a 401k company match if offered 
  • Max out your IRA
  • Invest the remaining portion into a 401k

Let’s take a look to see how that looks with numbers. We will use a 3% company match for our calculations and an annual gross income of $100,000.00.   

  • $3,000.00 for the company match ($100,000.00 X 3%)
  • $6,000.00 (IRA limit for 2022)
  • $6,000.00 invested in a 401k which is the remaining to reach 15%

The end annual result is that you are investing $6,000.00 into an IRA and $9,000.00 annually into a 401k. I would split the $15,000.00 investment dollars into bi-weekly payments throughout the year and would have all of the payments set up on an automatic payment system for ease. I would also recommend that you offset the IRA with the 401k. Preferably consider staggering your payments with your income payout dates. Therefore, if your payroll is on the first and third Fridays or days of the month, it is best to automatically invest in your IRA on the second and fourth Friday or day of the month that corresponds to the payday. 

Again, let me reiterate that this is the general rule of thumb for retirement, but you may have different retirement needs to keep in mind. It is best to work with a certified financial planner or CPA to help guide you through this process. Reach out to me for additional help with your retirement questions or with any questions about finances, budgeting, and investing. Remember to follow me @Budgetdog on Twitter, YouTube, Facebook, and Instagram for daily financial content and education.  

Published by Budgetdog

👨‍💼| CPA that quit 9-5 for @budgetdog 💵| Millionaire goal: 30 years old 💰| Paid off $76k of debt in 1 year 🏠| Paid off home BEFORE 30

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